It's Not Just a Stock Market!

Many people know something about stock markets but little about other financial markets. Let's take a look.

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Many people know something about stock markets but perhaps not as much about other financial markets. For example, did you know that bond market value exceeds stock market value? There are also commodities, currencies, real estate, derivatives, and other markets. Because these markets are highly interconnected, it pays to know more about them all.

Effective market participants are aware of the key categories of financial markets and their interrelationships.

Many Market Categories

Many people equate financial markets with the stock market. Fair enough. After all, the meteoric rise of U.S. stock markets in the late 1990s and its demonstrated potential for quick wealth creation has been etched into the minds of many. However, there is a lot more to financial markets than just stocks. Fixed income and cash instruments play a larger role than many newcomers to financial market realize. Let's take a look at some of the main 'categories' of financial markets.

Table 1: Size of Capital Markets 2005 ($ trillions)

GDP

Stocks

Debt (Public / Private / Total)

Bank Assets

U.S.

12.5

17.0

5.9 / 17.9 / 23.8

9.3

World

44.4

37.1

23.1 / 35.9 / 59.0

55.7

Source: International Monetary Fund (2006)

Stocks (a.k.a. 'equities'): As noted above, the stock market is the one that most folks are somewhat aware of. And it's certainly a big market. At the end of 2005, aggregate value of stocks was about $17 trillion. For those trying to figure out whether the stock market is overvalued or undervalued, one valuation 'yardstick' is a measure of stock market value to GDP. By this yardstick, stocks clock in at 17.0/12.5 = 1.36. The long term average (LTA) here is in the 0.7 - 0.8 range, which suggests what about the overall valuation of equity markets (using this yardstick, anyway)? Note that the same 'valuation metric' for world stocks clocks in at 37.2/40.9 = 0.91.

Debt (a.k.a. 'bonds,' 'fixed income'): Which market is bigger, stocks or bonds? Most people are surprised to learn that bonds are the larger market. From the chart above, total value of the debt market at the end of 2005 was $23.8 trillion compared to $17 trillion for stocks (40% larger). Debt markets are divided into two categories: public and private. In the U.S., public debt constitutes U.S. Treasury bonds of various duration worth nearly $6 trillion. Private debt is corporate bonds and other institutional 'paper' amounting to nearly $18 trillion in the U.S.

Bank Assets: Cash deposits and other bank holdings. The U.S. has $9.3 trillion in bank assets, while the world at large holds $55.7 trillion in bank assets. With U.S. GDP at $12.5 trillion and the rest of the world GDP at $44.4 trillion, note that the ratio of bank assets to GDP is lower in the U.S. than in the world at large.

Lesser Known But Very Important Markets

While the above markets tend to absorb lots of attention, you need to be aware of a few other 'outside' markets.

Commodities: Oil, copper, nickel, wheat, soybeans, cattle, lumber, silver, gold. These are all examples of commodities. (If you've ever seen the movie Trading Places, Duke & Duke was a commodities brokerage, and Eddie Murphy and Dan Akroyd made their millions by trading orange juice futures). For years, commodities have been an ignored group. Recently, however, they've been attracting attention. Why? Higher prices, of course. Some market sages argue that the world has underinvested in commodity-related capacity for years, which now is putting upward pressure on commodity prices as supplies tighten. Two commodities in particular are worth watching. Crude oil, likely needs little introduction due to the increasing prices of energy. Savvy market watchers should also keep an eye on gold and other precious metals as a proxy for confidence in monetary and financial systems.

Currencies: Every day trillions of dollars worth of currencies change hands. The U.S. dollar (USD), often regarded as the 'world's reserve currency,' trades with the most volume. Two other key reserve currencies that many folks watch are the Euro (€) and the Japanese Yen (¥). One important index that tracks the value of the USD against a 'basket' of major foreign currencies is the DXY. Tracking relative value of currencies can be an important factor in understanding market functioning.

Derivatives: By far, derivatives constitute the world's largest financial market. A derivative is a contract or agreement (usually with a specific payoff and time limit) whose value is based on the price movement of a cash instrument. Options, futures, and structured products are key categories of derivatives. Derivatives can be difficult to understand. This is what makes them potentially dangerous, since lack of understanding (and human nature) about the leverage and risks involved can lead to derivative mispricing. Since the notional world value of derivatives was estimated at about $285 trillion (that's right!) at the end of 2005 (IMF, 2005: 96), the potential for a derivatives-led 'problem' in the markets is certainly possible.

Stock Market Indices

Because stock markets have such a large impact on financial markets and (by extension) the economy at large, you should be aware of some key stock market indices.

Standard & Poors 500 (SPX): The SPX is an index based on the stock prices of 500 large U.S. corporations. Unlike the DJIA, the index is weighted according to market capitalization. This feature, coupled with the larger sample size, leads many to believe that the SPX is a more accurate reflection of broad stock market activity--at least among larger corporations.

NASDAQ Composite (COMP): NASDAQ stands for National Association of Securities Dealers Automated Quotations. It is the world's largest electronic stock market. Nearly 3200 companies are listed on the NASDAQ. The COMP is a stock market index based on all of the companies listed on the NASDAQ. Many regard the COMP as the 'tech' index, as many smaller companies and those engaged in newer, potentially high growth industries like to list on the NASDAQ. A defining feature of NASDAQ-listed stocks is that they contain four letters (Intel = INTC, Microsoft = MSFT). Stocks listed on the New York Stock Exchange and the American Stock Exchange contain one to three letter symbols (Citigroup = C, Procter & Gamble = PG, Walmart = WMT). Many traders follow a subset of the COMP called the NASDAQ-100, (NDX) which consists of only the top 100 NASDAQ listed companies by market cap.

Russell 2000 (RUT): The RUT represents an index formed from the stock prices of the bottom two thirds of a 3000 stock market index developed by the Russell Investment Group. Since the top 1000 stocks are removed, it provides a look at aggregate price movements of 'smaller' stocks. As such, it is the most popular index of stocks with a small market capitalization (a.k.a. the 'small caps').

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